Over the past 20 years, US real estate has outperformed both stocks and bonds. While we see several reasons for that trend to continue going forward, we also believe it is important for investors to develop an appropriate framework for their real estate (and overall) portfolio return expectations.
We speak daily with investors about the returns they see on individual real estate offerings and previously published an article about realistic return expectations for individual deals. But how do investors think about real estate as an asset class? What should they expect from a real estate portfolio? And, how does that feel relative to other asset classes today?
We believe that US real estate has the potential to continue delivering attractive relative returns over the long run. At the same time, we caution investors to moderate their expectations relative to history—both for their real estate allocation and for their broader portfolio.
Building a real estate portfolio: An introduction
Pushing investors to think at a portfolio level can feel like a thankless task. We impress our colleagues at the water cooler with our calls on individual stocks, but it can be much harder to win friends by speaking intelligently on portfolio construction or boasting about the limited correlation of our holdings. There’s an inner day-trader in most of us, and that spirit certainly holds true in real estate.
In our experience, the concept of a well-constructed real estate portfolio is typically an afterthought for most individual investors. We see one-off deals (or funds) and invest in the ones we like. Before we know it, we have a portfolio. Despite Cadre’s focus on identifying what we believe are the most attractive individual opportunities, we would argue that most of the positive attributes of private real estate come from owning a solid portfolio rather than a well-selected deal.
(Learn more about instant portfolio diversification through our Managed Portfolio.)
The question we will tackle here is: How should an investor think about building a “good” real estate portfolio? And, what exactly does “good” mean in the context of an economic cycle that, if not yet grey in the beard, is definitely sporting a salt and pepper look?
Here, we provide a simple framework to help investors build an effective real estate portfolio in a volatile stock market.
Three questions to ask before building a real estate portfolio
1. What level of return should I expect from a well-balanced real estate portfolio?
Without a response to this question, investors take three risks:
- Acting on unrealistic expectations
- Insufficiently assessing the risks they’re taking
- Over- or under-allocating to real estate relative to other asset classes
Thankfully, the institutional real estate community has tackled the return question by creating a number of public and private sector benchmarks. The most prominent is published by NCREIF (which tracks private real estate returns) and NAREIT (which tracks public REIT returns).
As with all publicly traded stocks and bonds, public REIT performance is readily available and analyzable. However, private real estate suffers from the same transparency and measurement issues as other “alternative” asset classes (private equity, venture capital, etc). For example, volatility—and therefore risk-adjusted returns—is difficult to measure. Notwithstanding their shortcomings, these indexes are a useful guide for investors looking to “level-set” their return expectations for the asset class.
To this point, the Pension Real Estate Association (PREA), an organization that represents the interests of some the largest U.S. institutional real estate investors, publishes a quarterly forecast of what its members think the NCREIF NPI index will return, by sector, over the next five years. In the Q4 2018 PREA quarterly survey, respondents on average expected unlevered U.S. real estate returns (i.e. before using debt) to average 5.4% per year through 2023. This five-year outlook is the PREA survey’s most publicized metric, but there are other data points in each survey that are worth understanding, such as the forecast for the upcoming year, property type-specific forecasts, and an evaluation of how the forecasts have evolved over time.
These forecasts are only projections, but we still find them directionally instructive as a guide for answering this first key question. Here’s a concrete application: Let’s say we’re comfortable as a private investor using 50-70% leverage (as we typically do at Cadre) at an average cost of 4-4.5%. This takes our projected baseline return as an equity investor from 5.4% to more like 7-8%. Assuming we can pick better than average assets and markets, execute on a value-add investment strategy, and exit opportunistically, we may further boost that portfolio return expectation to 9-10%. Not bad on a relative basis (as we will soon show), but also not 20%+ returns as we still hear from even many sophisticated investors as it relates to their private real estate expectations.
2. How do real estate returns compare with other options for my portfolio, like stocks and bonds?
We find it instructive that the same institutions that help set this PREA return forecast are on average targeting an increase in their private real estate allocations going forward. Simply put, they believe real estate offers attractive value relative to their other options.
Let’s examine those other options in a bit more detail: There is not an “industry-standard” forecast for public equities and debt. And we have yet to come across anyone that credibly predicts the S&P 500 on an annual basis. But we do pay attention to a handful of organizations that focus on intelligently assessing long-term return potential. As an example, the investment manager GMO has long published “7-Year Asset Class Real Return Forecasts” which they update quarterly. As of Q3 2018, they projected the 7-year real return for US large-cap equities as -5.2%. Assuming 3% inflation, that gets you to a still very underwhelming -2.2% nominal forecast. And US bonds don’t fare much better, with a 7-year forecasted real return of zero. According to GMO, the best-projected performer is Emerging Market equities, at 3.2% real (~6.2% before adjusting for inflation).
Short term, we don’t claim to be able to predict returns in real estate, let alone the broader market. But we do believe in the relative appeal of real estate over the long run. The opinions and actions of several respected players seem to support that view.
3. How do I achieve real estate exposure to the “right” way?
The final question is “now what?” How can I reconcile the “good” (portfolio enhancement) with the “bad” (tempered outlook for returns) while avoiding the “ugly” (loss of capital)? We suggest following these three guidelines:
- Diversify your bets. A series of small sector bets are more likely to achieve your portfolio objectives than a single concentrated investment. Interestingly, a well-respected study found that real estate diversification is more easily achieved through investing in multiple property types (as opposed to multiple geographies). The study’s other interesting finding was that investors need exposure to more than just a few properties in order to effectively achieve diversification. So while you may not need to own hundreds of buildings outright, you do need to own at least several small increments of real estate to achieve the desired effect of a diversified portfolio.
- Take a view on property types or invest with a manager that does. The study referenced above also implies that taking the right view on a specific property type can materially affect performance vs. the overall market. We even observe varying degrees of return potential within specific property sectors. For example, an analysis of NCREIF apartment sector returns shows that for the apartment sector, total returns on older properties (20+ years old) have fared better than those on newer properties since 2014. Therefore, investors who chose to overweight their portfolio during that time in vintage vs. new-build apartments would have been more likely to see outperformance.
- Choose the right vehicle for accessing real estate. Achieving the full benefits of diversified real estate requires more than creating a building collection—it requires creating a dynamic building portfolio. Return potential for certain properties and geographies changes over time, as does the overall size and complexion of an investor’s portfolio. Ideally, investors have the ability to adjust their real estate portfolios more frequently than buying or selling a small number of one-off buildings every several years.
How to begin building a real estate portfolio
Most informed investors today agree that real estate can be an attractive way to enhance the risk and return profile of their portfolio, but the next step is less clear: How do I effectively build real estate exposure?
At Cadre, we’ve dedicated our efforts to provide a better option: Access to institutional quality private real estate that allows for attractive relative return potential, diversification, tax efficiency, and liquidity optionality without the volatility of public markets. Our experienced team and data-driven approach are geared toward making informed bets on specific sectors and geographies in order to achieve returns above the industry average. To learn more about building your real estate portfolio or to become an investor, please request access to the Cadre platform.
- “Invest in the asset class that has outperformed the S&P 500 over the last 20 years” refers to the cumulative return (with full reinvestment of dividends) of an investment in the FTSE NAREIT US Real Estate Equity REITs index as compared to investment in the S&P 500 (using S&P Total Return data from CBOE) for the period from December 2000 – December 2018. Investments with Cadre are in private real estate interests and are materially different from investment in US equity REITs; real estate return data should not be used to estimate the return of Cadre investments. ↩︎
- prea.org ↩︎
- NREI. https://www.nreionline.com/investment/institutional-investors-plan-come-back-targeting-core-cre-new-intention s-survey-shows ↩︎
- https://www.advisorperspectives.com/commentaries/2018/10/23/gmos-7-year-asset-class-forecasts-still-favor-e merging-markets-over-u-s-stocks ↩︎
- https://www.dropbox.com/s/thaocz8clehp8kk/THRealEstate_THINK-US_Multifamily_Research.pdf?dl=0 ↩︎
The views expressed above are presented only for educational and informational purposes and are subject to change in the future. No specific securities or services are being promoted or offered herein.
This communication is not to be construed as investment, tax, or legal advice in relation to the relevant subject matter; investors must seek their own legal or other professional advice.
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Risk of Loss
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Investments offered by Cadre are illiquid and there is never any guarantee that you will be able to exit your investments on the Secondary Market or at what price an exit (if any) will be achieved.
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Opportunity Zones Disclosure
Any discussion regarding “Opportunity Zones” — including the viability of recycling proceeds from a sale or buyout — is based on advice received regarding the interpretation of provisions of the Tax Cut and Jobs Act of 2017 (the “Jobs Act”) and relevant guidances, including, among other things, two sets of proposed regulations and the final regulations issued by the IRS and Treasury Department in December of 2019. A number of unanswered questions still exist and various uncertainties remain as to the interpretation of the Jobs Act and the rules related to Opportunity Zones investments. We cannot predict what impact, if any, additional guidance, including future legislation, administrative rulings, or court decisions will have and there is a risk that any investment marketed as an Opportunity Zone investment will not qualify for, and investors will not realize the benefits they expect from, an Opportunity Zone investment. We also cannot guarantee any specific benefit or outcome of any investment made in reliance upon the above.
Cadre makes no representations, express or implied, regarding the accuracy or completeness of this information, and the reader accepts all risks in relying on the above information for any purpose whatsoever. Any actual transactions described herein are for illustrative purposes only and, unless otherwise stated in the presentation, are presented as of underwriting and may not be indicative of actual performance. Transactions presented may have been selected based on a number of factors such as asset type, geography, or transaction date, among others. Certain information presented or relied upon in this presentation may have been obtained from third-party sources believed to be reliable, however, we do not guarantee the accuracy, completeness or fairness of the information presented.